401(k)s are not a tax dodge for the rich

JimPhillips

Jim Phillips,
President of Retirement Resources, has been in the investment industry for more
than 35 years, the past 17 of which have been focused on 401(k) and 403(b)
retirement plans. Phillips has contributed to two books on 401(k), his articles
have appeared in a variety of industry publications, and he has been a frequent
speaker on retirement plan issues at national conferences. His work has been
acknowledged with multiple Signature Awards from the Plan Sponsor Council of
America, he has been named to the 2012 list of Top 100 Retirement Plan Advisors,
and he was a finalist in the 2012 Morningstar/ASPPA 401(K) Leadership Award. Jim
can be reached at: jim@ret-res.com His
company’s website is:
RetireWithMore.com

Is the 401(k) a rich person’s tax dodge that should be eliminated? Or, is it a smart investment in America and the middle class?

This article aims to make three points: The major beneficiaries of 401(k) are middle-class workers, business owners must continue to be incented to offer these plans in the workplace, and Uncle Sam is a major beneficiary of the tax-deferred treatment of 401(k) deposits.

There’s surprisingly little agreement on how to define who is rich and who is middle class in America. A 2008 Congressional Research Service report summarized three surveys in which people were asked to sort themselves by socioeconomic class. Those participants with family incomes ranging from $40,000 to $250,000 considered themselves middle class. In their 2010 report Middle Class in America, the U.S. Commerce Department used income brackets of $50,800 and $122,800.

For this article, let’s define middle class as individuals with income of between $40,000 and $115,000. Let’s say that the top 2%, by income, are rich. That’s roughly the $250,000 income level. That leaves us with a swath of the population in between these two, earning $115,000 to $250,000, which we will call upper middle class.

Unless you are a member of Congress, you probably don’t have a generous lifetime pension coming your way. Your retirement income needs will be met primarily by Social Security and private savings. For many, this income will need to be supplemented by some form of work during “retirement.”

How much do you need to live comfortably in retirement? A frugal retiree might be able to get by on half of their pre-retirement income, but a common rule of thumb is that it takes about 75% of one’s pre-retirement income to maintain a similar standard of living during retirement.

How much replacement income will Social Security provide? The 2013 benefit levels, at full retirement age, are as follows: 90% replacement of the first $9,492 of annual income, 32% replacement of the next $47,724, and 15% of income above $57,216. The maximum annual benefit anyone can receive in 2013 is $30,396, and to earn that amount, one has to have been at the Social Security maximum earning level for many years.

Now let’s look at what gaps exist between the 75% income replacement target and the Social Security benefit each group is likely to receive. This gap is what the 401(k) is designed to fill.

Incomes below our middle-class cutoff: At the $40,000 level, Social Security replaces about 46% of pre-retirement income. A worker at the $20,000 level would see income replacement of about 60%. The gap between these replacement amounts and the 75% target level isn't insurmountable. Budget stretching and perhaps some part-time work may allow these individuals to maintain their pre-retirement lifestyle after they retire.

Middle class: If middle-class income starts at $40,000, the highest Social Security replacement ratio this group can hope for is 46%. At the top middle-class income level, $115,000, Social Security will replace just 24% of pre-retirement income. There’s no way to stretch 24% far enough to maintain a similar standard of living during the 20 to 30 years that retirement commonly lasts now-a-days. Members of the middle class will need to have substantial amounts of private savings to avoid falling onto the social safety net during their “golden” years. Systematic payroll deductions to 401(k) savings is the best hope this group has to avoiding falling into poverty during old age and becoming dependent upon the government for all their financial needs.

Upper middle class: The highest Social Security replacement rate this group can qualify for is 24% and at the $250,000 earning level, just 12% of income is replaced by Social Security. 401(k) savings could provide important retirement income for this group. But, the IRS characterizes those earning over $115,000 as “Highly Compensated Employees” and imposes extra restrictions on how much they are allowed to save.

Rich: Not to pity the rich, but Social Security will replace 12% or less of the pre-retirement income of this group. They have to rely almost exclusively on private saving. This is where the rich-person 401(k) tax dodge comes in. Actually, it doesn’t, because there isn’t one, thanks to the way the IRS wrote the 401(k) rules. As mentioned above, IRS rules impose extra restrictions on 401(k) savings of those earning over $115,000 annually, and any income above $255,000 is completely ineligible for 401(k) savings purposes.

Recapping: Workers earning above $115,000 face the biggest income replacement challenge in retirement. Social Security will replace no more than 24% of their pre-retirement income, and IRS regulations limit the amount they are allowed to save in a 401(k).

It is the middle-class workers, with roughly $40,000 to $115,000 of income that the current 401(k) system has the potential to benefit the most. However, those of us who work regularly with them know that middle-class workers can be marginal retirement savers.

They need the structure (payroll deduction savings) and tax incentive (pretax deposits to lessen the take-home pay impact) to tip them over the edge into joining their employer’s 401(k) plan. Without the structure and incentive, far fewer workers would engage in retirement saving.

Congress should note that business owners will be less inclined to offer these critical 401(k) savings plans to their workers if their own benefit is further restricted. Even a small employer incurs thousands of dollars of annual costs associated with the administration and oversight of a 401(k) plan, not to mention company contributions, the fiduciary risk, and bear market complaints around the water cooler.

Congress should also understand that 401(k) tax breaks are smart federal investments in two ways:

1. The tax isn't forgiven on pretax 401(k) deposits; it is postponed. Uncle Sam is no dope. By waiting, he gets a slice of a much larger pie. If a 401(k) earns 7% annually over time, then every 10 years, the taxable amount doubles. It is a great deal for the Treasury, which can finance its cash needs at about 3% in the meantime. Essentially, Uncle Sam has a lucrative business, making a fat interest spread off the money growing in 401(k)s.

2. The second investment aspect of 401(k) is that by providing a small incentive now, to encourage people to provide for their own retirement income needs, the Government can drastically reduce the number of old people that will be sucking the system dry in a few years. For perspective, an estimated $9 trillion has been saved to-date in 401(k) plans. If Uncle Sam had to step in and plug a retirement income hole of that size, our current federal budget deficit would look like child’s play by comparison. An ounce of prevention...

Summing it up, the current 401(k) system offers its biggest potential benefit to middle-class workers, who need the discipline and tax incentives to motivate them to save. Without adequate individual savings, millions of additional Americans will become wards of the state. Business owners’ personal benefit from 401(k) is already limited. Further restrictions may provoke them to cease offering these plans in their workplace.

Finally, the deferred taxation of 401(k) plans is a good business deal for the Treasury, as the growth rate of the deferred balances is greater than the Treasury’s cost of financing during the accumulation period. Messing with the current system will have severe negative consequences for America and Americans.

A call to action: 401(k)s may soon become the target of shortsighted members of Congress, who see them as a near-term revenue source. Removing the current tax incentives will cause large numbers of individuals to stop saving for the future, and may cause large numbers of employers to stop making these plans available to their employees.

The long-term consequence of these actions will be potentially devastating to America, with tens of millions of older Americans on public assistance and younger Americans being taxed heavily to cover those costs. If you are concerned about this, please contact your elected representatives and tell them not to mess around with the 401(k) system.

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